Sunday, December 23, 2007

Nobel-winning economist Vernon Smith had an editorial on housing issues in the WSJ the other day here, but you need to be a subscriber -- Murdoch hasn't opened the site up yet!).

Vernon makes a few points, including blaming the "housing bubble" on cuts in capital gains taxes for houses. That might have had some impact on housing prices, I have to agree, but I don't think that was the only reason for the rather spectacular rise in housing prices the last 10 or so years (low interest rates, increased credit available for housing purchases, and simple supply and demand also play large roles).

But Vernon also argued that the investments in housing were to a great extent a waste of resources and went mostly to the rich. Even more bothersome to me, he compared the housing investments to the investments made during the late 90's tech boom and argued that those tech investments were good, in that they contributed to productivity gains for companies.

It would be good to have some more facts at hand, but on the basis of my observations, I think he has it backwards. The housing investments have been for housing, which is generally occupied. And these investments have obviously not just been for the wealthy -- the wealthy don't qualify as subprime risks. Generally the housing boom has expanded the supply of housing, and made home ownership more affordable for many of lower income. We should all keep that in mind when criticizing the mortgage industry for making subprime loans -- even with a lot of defaults, there will still be a lot of lower income folks in houses that they own instead of rent. That is a good thing.

And for Vernon Smith to argue that the investments of the tech boom were all good makes me think he must not have been watching during that period. Much of the investment of the tech boom was not in real capital but instead in human capital. All the startup internet firms were not investing much at all in physical capital; they were investing in salaries of programmers and managers, many of whom had advanced degrees. And these companies were also employing armies of consultants and investment bankers, who are also obviously of higher income classes. Some companies were investing in physical capital, such as the firms in the telecommunications industry that built more fiberoptic network than could be economically justified even at zero discount rates.

So before we condemn the housing investments as clearly wasteful, especially in comparison to the investments of the tech boom, we should pause and, even better, collect some data and do some analysis.

The story two weeks ago about the NIE (National Intelligence Estimate) on Iran and how that country likely stopped pursuing nuclear weapons in 2003 still demands explanation. Some folks think it was sabotage by some elements within the US intelligence community. That is possible, but not my favored explanation. What strikes me as incredible is that the administration seemed to be caught off guard by the report. How could that possibly happen? The report had to be in the making for weeks, and I just cannot believe that the top intelligence officers would not know how it was going to come out. A conspiracy that deep could never be kept secret. Is there another explanation for the report that also explains the seeming surprise/ignorance of the administration?

Now in today's papers comes another story, citing a US official crediting Iran with helping (!) to limit violence in Iraq. This also comes just in advance of another meeting between US and Iranian diplomats.

Could the NIE estimate be more purposeful than many think? Maybe the deal, even implicitly, is that the US will back off the rhetoric on Iran's nuclear ambitions, and in turn Iran will back down on its support of Iraqi violence. Maybe there is some signaling going on from each side, with the intent of moving forward in a more friendly, negotiated fashion.

This theory explains the Administration's seemingly surprised and ignorant stance as being much more strategic, using the feigned ignorance to avoid admitting that they are offering Iran a fig leaf.

The fact that both sides seem to be giving in a little supports my theory. The test of competing theories will lie in what happens in the coming months.

But all in all, the NIE report remains another case of "there's something happening here and we don't know what it is."

Friday, November 16, 2007

Conflicting data and interpretations are confusing our understanding of personal income growth over the decade of 1996-2005. Politicians are using the data and analyses that support their agenda: are we surprised? My view of the overall media and political landscape is that they are being overly influenced by data and analysis suggesting that US society is becoming more unequal in regard to income and that only certain individuals, generally the already-rich, enjoyed income gains over the last decade.

My colleague Matt Slaughter, recently with the Council of Economic Advisers, likes to point to US Census data from 2000 to 2005 that purportedly shows, in Matt’s words: “income growth has been extremely skewed, with relatively few high earners doing well while incomes for most workers have stagnated or, in many cases, fallen. Only 3.4% of workers were in educational groups that enjoyed increases in mean real earnings from 2000 to 2005…: mean real money earnings rose for workers with doctorates and for workers with professional graduate degrees (i.e., MBAs, JDs, and MDs) and fell for all others.” Surprisingly, the set of workers with just undergraduate degrees had no real income growth between 2000 and 2005.

That sounds pretty bad, and a lot of politicians are using the data to support their claims of rising inequality and the need for some redistributive policies. However, let us be clear about what the data actually show – or more important, what the data do not show. The earnings of workers who had doctorate or professional graduate degrees in 2005was higher than for workers who had doctorate or professional graduate degrees in 2000. Yes. But this does not say anything about any particular individual’s earnings. The people who were in the workforce with doctorate and graduate professional degrees in 2005 were different from the set of workers with doctorate and graduate professional degrees in 2000. The same goes for the set of workers that did not have such degrees – the people in that category in 2005 were not necessarily in that category in 2000. In fact, it is very likely – a certainty – that some of the people without doctorates and graduate professional degrees in 2000 had such degrees in 2005!

So what I have always argued in the face of these data is that they do not say anything about any specific individuals, in regard to changes in their incomes.

This kind of analysis and data can be useful. For instance, if we think the economy is in a steady state, with equal cohorts of people moving through the age and education ranks, then a decline in earnings for, say, undergraduate degree holders would suggest that something is happening to the value of undergraduate degrees. But I don’t think this is the world we live in. The set of people with undergraduate degrees is very different today than it was even five years ago: the mix of degrees is different, the age and experience of the workers is different, and even the gender of the workers is different (and we know there are income differences by gender). The data may only be telling us about the makeup of the set of workers with professional graduate degrees (or undergraduate degrees) and how that makeup differs between 2000 and 2005.

Suppose, for example, that folks with graduate professional degrees were just hitting their peak earning years in 2005, while those with only undergraduate degrees had been hitting their peak earning years in 2000. Then it would be natural to see earnings growth for graduate degrees between 2000 and 2005 and earnings declines for the undergraduate set between the same years (as in 2006, the undergraduate set would have relatively more “early career” workers).

A different study tells a very different story. I first saw the storyreported on the editorial page of the Wall Street Journal, and Matt Slaughter sent me the actual study, “Income Mobility in the US from 1996 to 2005,” which was done by the Treasury. I have not seen any other media references to this report!

The Treasury study tracks the same taxpayers between 1996 and 2005. This analysis is relevant if we are interested in how specific individuals change their income levels, both absolute and relative to others, as they age and gain experience. It is not an answer to the question of “how do people with undergraduate degrees in 2000 compare to those with undergraduate degrees in 2005” but instead to the question of “how much does an average or median worker’s income change over a ten year period?” I think this latter question is extremely important, as to a great extent it is people’s ability to improve their relative and absolute standing that governs their perspective on the overall fairness and justice of the society in which they live.

So what does the Treasury study say? First, that the median taxpayer saw a 24% increase in real income over this period. Second, that about half of all taxpayers who were in the lowest 20% of income earners in 1996 moved to a higher income quintile within 10 years. Third, that the degree of mobility between this decade and earlier decades is basically unchanged. Four, taking the very highest income earners, those in the top 1/100th of one percent, 75% of those were in that category for 1996 fell out of it by 2005 – and the real earnings of that category actually FELL over the period.

The overall picture of the US society from the Treasury study is one of significant movement between income classes, with a general increase in earnings for all classes. This is what we should expect. Ten years ago someone entering the workforce with an undergraduate degree in computer science might be making $30,000. Today they would likely be in the top couple percent of the income distribution.

What would be most distressing to me would be data showing that folks in the lowest income category in one year were extremely likely to still be in that category ten years later. This is definitely not what we see.

Another study worth looking at is the Pew Charitable Trusts study on the Economic Mobility of Families Across Generations. This study looks at the movement across income classes from one generation to another. I will leave readers to look at this on their own, but when I read it, I was very comforted to see the kind of movement from poor to rich and from rich to poor that I think characterizes a truly great society.

Sunday, November 11, 2007

Here's a problem to test our principles -- or to force us to choose which one is more critical.

In nearby Vermont, a 61-year old woman -- a defense lawyer, no less -- called the Vermont Fish and Game service to help remove a dead deer from her yard (some details are here.) Upon looking around her yard, they discovered numerous marijuana plants (at this time of year, probably nice and ripe!) as well as some dry ganja. Such actions -- growing and possession of relatively large amounts -- qualify as serious felonies, with up to 30 years in prison.

The local prosecutor declined to charge the woman with felonies, opting instead for misdemeanor charges and then even dropping those in favor of a court-supervised "diversion" program -- kind of like what teenage kids might get for possession of alchohol.

It is relevant that this local prosecutor, Robert Sand, has in the past spoken out against our country's drug laws, saying they are not working and arguing for decriminalization of drugs like marijuana. Hallelujah!

Ah, but...The law is the law, is it not? For a prosecutor, elected to enforce the laws of the State, to turn his head on what the State currently considers a serious crime...is that right? And did the prosecutor go easy because it was a 61 year-old woman, and a peer, in that she was a lawyer?

If Mr. Sand thinks that marijuana should be legal, I agree 100% with him. But I am not sure that given his job, he can do what he did. If he cannot enforce laws that he thinks are bad, then I guess he needs to resign.

Or is a little civil disobedience on the part of public prosecutors OK?

Friday, November 02, 2007

A colleague passed on to me the link to a special issue of The Economists' Voice, an e-journal from the Berkeley Electronic Press. The special issue is on climate change, and features some notable economists -- Kenneth Arrow, Joseph Stiglitz, Thomas Schelling, among others (three Nobel winners there!). The link for the journal is here but I think you need to register to read the full article.

At least some of the articles refer to the Stern report, and the reviews of that report that I wrote about in my latest post. Arrow, for example, explicitly mentions critics of the Stern report, and their main critique (insufficient discounting of the future) but he does not mention them by name.

Unfortunately the articles in the BE Press do not live up to my expectations for the authors and they do not match the rigor and clarity of the Nordhaus and Weitzman articles in the Journal of Economic Literature. Go read the BE Press for yourself and compare it to Nordhaus' article, or Weitzman's, in the JEL. If you don't see the obvious differences, let me know.

Stiglitz does not address any of the economics of climate change but plows ahead with major policy recommendations anyway. Great economics!

Arrow mentions the discounting problem, and agrees with much of it, but at the end of his article he does some back of the envelope calculations and concludes that the benefits of stabilizing CO2 are worth the costs. I wish he had made his calculations more consistent with, for example, Nordhaus and Weitzman so that we could compare the assumptions and see where they are different. Arrow does some things for ease of calculation that strike me as questionable: he converts a loss of 20% of output beginning in the year 2200 with a lower growth rate of output between now and then. While the growth rate calculations work out, I am not sure that the utility/welfare of the different time paths are the same: the second scenario has output lower in all the years up to 2200.

Schelling, as usual, is rather good; I am a fan of his (read The Strategy of Conflict, his classic on game theory). Schelling is open about uncertainties, including those of water vapor and clouds, and he even mentions favorably the ideas of geoengineering. He also mentions that the "precautionary principle" has been likened to the principle of "never do anything for the first time." I like that! But the article is also marred with jabs at the Bush administration (come on, guys); he mentions extreme bad outcomes such as the sea level rising by 20 feet but does not mention extreme good outcomes such as little climate change, favorable effects on agriculture and low mitigation costs; and he ends with this oddity: "How should we respond to that kind of uncertainty? Wait until the uncertainty has been resolved completely before we do anything, or act as if it’s certain until we have assurance that there’s no such danger? Those two extremes are not the only alternatives!" (p. 5, Economists’ Voice www.bepress.com/ev July, 2007).

All in all, I remain very impressed with the Journal of Economic Literature articles and will look at the BE Electronic Press, at least this one journal of theirs, somewhat differently.

Friday, October 19, 2007

In the latest issue of the Journal of Economic Literature, two papers deliver devastating reviews on the Stern Review on the Economics of Climate Change. The reviews are by serious, mainstream economists: William Nordhaus of Yale and Martin Weitzman of Harvard. These are not individuals and articles that can or should be ignored. Of course, they will be ignored by the mainstream media – while at the same time Al Gore’s receipt of the Nobel Prize carries the media day.

The Journal of Economic Literature is the sister publication to the American Economic Review and is put out by the American Economic Association, the leading professional society for economists. Abstracts of the papers, and instructions on how to buy them, are available here.

I have always said that my objections to the prescriptions of the most vocal climate change advocates are on three levels: one, the climate models depend too much on positive feedbacks that are not understood; two, the models have not really been tested, but instead are calibrated to the historical data; and three, even if one accepts the models, one then has to move into the economics of optimal policy, and there the best analysis suggests relatively modest reductions in carbon emissions for the near term. I like to ask environmentalists to summarize their prescriptions with the appropriate tax per barrel of oil: tell me what you think the price of oil should be increased by, in order to recognize the impact of carbon.

But back to the reviews of the Stern Review. So the Stern Review made big headlines when it came out, as it was commissioned by the UK government and was ostensibly a serious analysis of the economics of climate change. Both Nordhaus and Weitzman deliver fatal blows, although they try to temper it a bit. Here is a quote from Nordhaus:

“The central methodology by which science, including economics, operates is peer review and reproducibility. By contrast, the (Stern) Review was published without an appraisal of methods and assumptions by independent outside experts. Nor can its results be easily reproduced…(this) does mean that fatal flaws in evidence and reasoning, which might have been caught in the early stages under normal ground rules, may emerge after the report has been published.”

Weitzman says,

“However, in my opinion, Stern deserves a measure of discredit for giving readers an authoritative-looking impression that seemingly objective best-available-practice professional economic analysis robustly supports its conclusions, instead of more openly disclosing the full extent to which the Review’s radical policy recommendations depend upon controversial extreme assumptions and unconventional discount rates that most mainstream economists would consider much too low.”

Now in the spirit of full disclosure, I recommend everyone look at the papers for themselves. Nordhaus and Weitzman go out of their way to point out the positive aspects of the Stern Review. But the overwhelming conclusion, especially from Nordhaus, is that the extreme policy prescriptions of the Stern Review are way overblown.

To summarize the contrast: The Stern Review calls for a carbon tax of $350 per ton of carbon in 2015. Nordhaus’ model, which has been peer-reviewed many times, calculates the optimal carbon tax in 2015 to be ONE-TENTH of that, or only $35 per ton carbon. I find it useful to put these quantities in terms of something we understand more readily: $350 per ton carbon converts to $1 per gallon of gasoline, while $35 per ton carbon converts to 10 cents per gallon of gasoline. We are talking big differences here.

So what is wrong with the Stern Review’s economics? It is real simple – they use an extremely low interest rate, close to zero. Everything follows from this, and in my opinion, the assumption is crazy.

The essence of carbon policy is that we incur costs today for benefits many years into the future. Changing our energy usage patterns will be costly for us today, and the benefits of lower temperatures come 50, 100 or even 200 years in the future. Any time you are considering investing today for benefits in the future, you have to consider the interest rate. Investments to stabilize climate should yield returns – a rate of interest – in the ballpark that other investments yield. If we can invest in human capital, for instance, and earn 10% per year, why should we invest in climate stabilization if it yields a zero rate of return?

Nordhaus has some great examples to illustrate the unreasonableness of using a zero discount rate for climate policy: “Suppose that scientists discover a wrinkle in the climate system that will cause damages equal to .1 percent of net consumption starting in (year) 2200 and continuing at that rate forever after. How large a one-time investment would be justified today to remove the wrinkle that starts only after two centuries? Using the methodology of the (Stern) Review, the answer is that we should pay up to 56 percent of one year’s world consumption today…In other words, it is worth a one-time consumption hit of approximately $30,000 billion today to fix a tiny problem that begins in 2200…the Review would justify reducing per capital consumption for one year today from $10,000 to $4,400 to prevent a reduction of consumption from $130,000 to $129,870 starting two centuries hence and continuing at that rate forever after.”

Another point in this criticism is the essential inter-generational fairness issue. Per capita income worldwide has been growing at around 1.3% over many decades – and this is the number that the Stern Review uses. At that growth rate, per capital world consumption will grow from today’s $10, 000 to about $130,000 in two centuries. Which generation is the relatively poor generation? Are we so sure that we are impoverishing our children and our children’s children? What about all the new technologies, institutions such as democracy and market economies, physical infrastructure, and knowledge that we are bequeathing them? Do we not think that people 200 years from now will enjoy more leisure, better health, better technology, and generally be better able to pursue life, liberty, and happiness?

Read the articles, they are really convincing. For most of the media, of course, that will be too difficult. Much easier to report on Al Gore winning an Academy Award – oops, I meant a Nobel Prize.

On Monday, October 15, 2007, I saw the invisible hand at Dartmouth College.

Vinod Khosla, a founder of Sun Microsystems and now a venture capitalist focused on renewable energy, gave a talk to Tuck and Thayer students and faculty. It was truly amazing. Khosla laid out his vision of how the world was going to transition away from a petroleum and coal-based energy economy to one that would rely on renewable, low-carbon emitting forms of energy. But more than just the vision, Khosla is part of the invisible hand of market economics, of what I recall so fondly from graduate school as “price theory.” Khosla is playing a fundamental role in bringing together the scientists, entrepreneurs, professional managers, and investors that are needed to form the organizations that will provide us our energy needs of tomorrow.

But the most important part of his talk was his incredible optimism, his beliefs in the power of science, entrepreneurship, and markets. He described some of the truly amazing technologies that he is funding, from designer cells that focus all their internal mechanisms on producing butane, to “sub-critical” nuclear reactors, to cellulosic ethanol, to significant improvements to the mundane old internal combustion engine.

Throughout it all, he focused on the pragmatic, and the scalable. He will invest in projects that may not become huge, but primarily he wants to develop sources of energy that can supplant significant amounts of petroleum and coal. I may disagree with his views on climate change (see my other post of today) but I don’t disagree that we do have to transition away, gradually, from petroleum and coal.

It was wonderful when he dismissed an engineer’s criticism of biomass energy on the basis of thermal efficiency. I have always thought that engineers focus way too much on process efficiency, in regard to what percent of some input source (e.g., wattage from the sun) is transformed to the final product. What really matters is the economic efficiency of the process – dollar value of inputs vs. dollar value of outputs. BTUs are not all the same – BTUs in the form of sunshine are not all that useful in economic life, but BTUs in the form of gasoline are valuable.

I left feeling invigorated, and confident that if our politicians do not restrict our freedoms too much, there is little that we cannot accomplish. Certainly my confidence in thinking that my children will be able to enjoy even better forms of heating and cooling, lighting, and transportation was tremendously enhanced.

Sunday, October 14, 2007

OK, let's all give Al Gore due credit for winning much of the world over with his efforts over climate change. It is true, the fellow has been quite relentless on the issue for some time. Now he gets the Nobel Peace Prize.

I still don't quite understand the Peace Prize aspect of this. The original language in Alfred Nobel's will is "to the person who shall have done the most or the best work for fraternity between the nations, for the abolition or reduction of standing armies, and for the holding and promotion of peace congresses." The story with climate change is allegedly that changing weather patterns will cause new strife between nations, especially in regard to migration and fighting over water resources. Maybe. Maybe not. Seems to me like many of the predictions over effects of climate change -- might happen, might not happen, and if it does, might be easier to mitigate down the road than try to prevent right now.

At about the same time that Gore got the Nobel, a judge in the UK ruled that the UK government may send the film to all secondary schools and they can show it to students, but they must note that the film is politically one-sided and is inconsistent with even majority scientific opinion in places. The ruling was in a lawsuit filed by an heroic parent -- who won back 2/3 of his legal costs since the judge ruled that he substantially won the case.

Here is one quote from the "guidance" that teachers in the UK must be given if they are to show the film:

The High Court has indicated that schools can lawfully show AIT to pupils without breaching ss. 406 or 407 of the Education Act 1996, but that, in doing so they must bear in mind the following points:

• AIT promotes partisan political views (that is to say, one sided views about political issues) • teaching staff must be careful to ensure that they do not themselves promote those views; • in order to make sure of that, they should take care to help pupils examine the scientific evidence critically (rather than simply accepting what is said at face value) and to point out where Gore’s view may be inaccurate or departs from that of mainstream scientific opinion; • where the film suggests that viewers should take particular action at the political level (e.g. to lobby their democratic representatives to vote for measures to cut carbon emissions), teaching staff must be careful to offer pupils a balanced presentation of opposing views and not to promote either the view expressed in the film or any other particular view.

Dr. William Gray, climate change skeptic and a very respected US meteorologist (the two are almost now mutually exlusive, to the detriment of science), has this to say: "We're brainwashing our children."

Mystery still surrounds the September 6 strike by Israeli aircraft deep inside Syria. Much of the mystery is that the event was initially hardly noted -- particularly that Syria itself did not even issue a complaint. Slowly now more information is coming out. At the time of the event, one telling comment I heard was that there was an amazing coincidence of interests between Israel and Syria in keeping their mouths jointly shut.

New reports suggest that that telling comment was true. Papers today are reporting that the Israeli fighters hit a partially constructed nuclear reactor -- a Syrian reactor being built, supposedly, with the help of the North Koreans. If this is true, it explains why Syria did not complain too loudly. Israel's silence, of course, needs no explanation.

Also of interest is the ease with which the Israeli planes accomplished their mission.

It may be, however, that the Israeli's acted too fast. Clearer evidence on North Korea helping the Syrians build a reactor would be helpful.

I bet we hear more about this event over the next months. It is one of those things that gets a tiny story at first, and when you read it, you think, like Bob Dylan in Ballad of a Thin Man: "Because there's something happening here but you don't know what it is..."

Wednesday, September 26, 2007

There is a speech I would not have looked forward to giving -- "welcoming" President Mahmoud Ahmadinejad to the Columbia campus. Luckily it fell to President Lee Bollinger and not to me. Talk about a no-win situation.

President Bollinger, who was Provost at Dartmouth for a few years, scored about 80% on my grading scale. Unfortunately, the areas where he slipped up were rather serious.

So much of his speech is right on the point. Put most simply, we do need to hear what our adversaries have to say. For all the critics of the Iraq war, one would think that there would be overwhelming support for getting the best information possible on Iran before that comes to war as well. And the US can and will take the high road: let our citizens hear Ahmadinejad out, and let them make political decisions. We have elections coming up (lots of evidence of that in Hanover tonight, with all the Democrats in town) and voters should be seriously considering who will best handle the Iranian situation.

But...why then engage in some pretty nasty name-calling? Why call the President of Iran a "petty and cruel dictator?" Why say "I doubt that you will have the intellectual courage to answer these questions?" Why the scornful "You are either brazenly provocative or astonishingly uneducated?" These are soundbites unbecoming of the President (or even a professor) of one of the world's leading liberal arts universities.

While many seemed to enjoy the sight of Ahmadinejad having to listen to Bollinger's insults, I actually have to hand it to the President of Iran for his response: "In Iran tradition requires that when we in a person to invite to be a speaker we actually respect our students and the professors by allowing them to make their own judgment and we don't think it's necessary before this speech is even given to come in with a series of claims and to attempt in a so-called manner to provide vaccination of some sort to our students and our faculty." (Quoted from the Washington Post transcript, with some obvious grammatical problems.) No doubt, Ahmadinejad is no intellectual light weight. Sparring with him would be a good fight.

I also think that Bollinger should have held back on the long list of complaints against Iran. Get up, say why Columbia is having him speak and why people should at least accept that if not be proud of it, and then give him the podium. Save time for questions -- the real learning was in President Ahmadinejad's responses to questions, not in President Bollinger's prepared remarks.

It was a tough situation to be in, with half of the listeners sure to be ticked off no matter what you did. The job of University President is not an easy one.

Monday, September 17, 2007

What a difference an election makes. On Sunday, French Foreign Minister Bernard Koucher said that "the world must prepare for the worst" in regard to Iran and, when pressed, said that the worst was "war." See the Deutsche Welle's story. (Ah, the Deutsche Welle, that reminds me of when I used to listen to DW on a shortwave radio -- and the BBC, before I lost my trust in that service.)

While backing down a bit on Monday, France stuck to its guns pretty well, saying that since UN sanctions will never happen, a set of EU sanctions similar to those of the US are possible: see the International Herald Tribune.

Le petit Nicolas, as one of my French friends refers to the French President, is making quite a stir on the international scene. What a shame he wasn't around when the US had to serve the world and take out Saddam Hussein.

Sunday, September 16, 2007

An article in Friday's Wall Street Journal, written by Chad Terhune, describes new health insurance policies being offered by some insurance companies. I can't give a reference to the WSJ piece, but another paper reports on it here. The ones offered by American Community Mutual Insurance are particularly interesting. They are targeted at the "healthy young" and offer low annual premiums, around $1000 per year. That doesn't get you much, however, as there is a rather small maximum benefit and a large deductible. What it does get you is the option to buy a much larger benefits cap -- up to $5 million -- if you do get sick and want to initiate the higher coverage. "Coverage on Demand," the company says. Of course, that additional coverage is expensive. It HAS to be, because only the ones who buy it will need it! So given the adverse selection that has to happen, is there a price that will allow the company to break even at least, and that will attract some customers into the program? Or at any price, will the only customers who sign up be so costly that the company will have to lose money? The higher the price of the "coverage on demand," the sicker and more costly will be the individuals who sign on. Or, maybe, the individuals who get sick will have enough uncertainty and be so risk-averse that they will buy expensive coverage even when their medical bills will not be all that large.

There is a large market of rational individuals who find medical insurance too expensive and therefore go uncovered, so I can understand the experiments at attracting them. And there are a lot of new plans coming out, especially as some states like Massachusetts require insurance. The fine print is going to lead to a lot of litigation, I predict: what maximum benefits really are, whether they were disclosed, non- covered conditions, etc.

Great case to cover in a class on the classic information economics problems of adverse selection and moral hazard.

Monday, September 10, 2007

A few observations on the testimony today of General Petraeus and Ambassador Crocker. I listened to some, watched a bit on TV, and based on what I saw:

1. If the White House communicated as well as these two fellows (heck, half as well), these hearings would not be happening – because the Democrats would not be in charge of Congress.

2. The moveon.org ad in the NYT brings rational discussion to a new low. To refer to General Petraeus as General Betray Us not only gratuitously insults someone who appears to really care for our country, and obviously works hard at his job, but it demeans the debate over the war. Shame on them.

3. The Democrats are really scared, because they see that if they do indeed win the White House next election and keep control of Congress, any pullout from Iraq will be their decision – and they could well be in a position of explaining to their supporters why we have to stay in even longer. Political posturing is cheap for them now, but they realize that if they were actually in control, they would be making the same decisions.

4. I never understood why “exit” is valued so highly, even if we succeed in stabilizing the situation. I see tremendous value in having, say, a US military base on the Iran/Iraq border – something widely reported today. What, strategically, is bad about having 100,000 well-trained and well-equipped troops on the borders of Iran, Syria, Kuwait, and Saudi Arabia?

So no sooner did I write my post below about how Apple rarely has sales, and they promptly cut the price of the iPhone by $200. I did not mean by “sales” the (anticipated) cutting of price after an initial product launch, but instead the kind of sales like “back to school” or “holiday” or “Labor Day.” Cutting of price after an initial launch can often be wise, and I like to refer to it as “temporal versioning.”

Versioning is generally the idea of offering different versions of the same basic product at different prices. If you offer a deluxe version at a high price and a basic version at a lower price, you can effectively price discriminate, with some folks buying the high-priced version and the more price-sensitive folks going for the cheap version.

Critical to this strategy is separation: the two versions have to be kept distinct enough so that the folks who like the deluxe version won’t see the cheap version as almost as good, and at the lower price, a better deal overall.

With temporal versioning, separation is also temporal -- the time between the high price period and the low price period has to be long enough to keep everyone from seeing the sense in waiting for prices to fall.

Apple seems to have not temporally separated its versions well enough. Nice strategy, but off a bit on the implementation. The consumer outcry is pretty good evidence of the error. Interesting, often when discussing price discrimination students will mention the anger when some consumers discover that others are paying a lower price (economists like to walk down an airplane’s aisle asking people what they paid for their seat). My response to this is often: who cares if the consumers are mad? With Apple, and the importance of repeat purchases, consumer anger could translate quite powerfully into lower sales.

Saturday, September 01, 2007

So Pete Seeger has written a new song, "Big Joe Blues" that recognizes Seeger's earlier errors in overlooking the evil of the Stalin/Soviet empire:

He ruled with an iron handHe put an end to the dreamsOf so many in every landHe had a chance to makeA brand new start for the human raceInstead he set it backRight in the same nasty place

I admit to a certain attraction to songwriter/singers like Seeger, Lennon and Dylan. I think it is the pureness of their idealism, no matter how wrongheaded it might be, I just have to admire it. "Imagine there no possessions." Well, I can imagine that, and it is not pretty, but I can understand what Lennon was trying to accomplish.

Steinbeck' stories are similar. A very socialistic message, but one that hits you very hard and that cannot be ignored.

The New York Times reports that Apple and NBC disagree over pricing of NBC’s video content on the iTunes site. Apple prices all TV shows at the flat rate of $1.99; NBC wants more popular shows to sell for more and to be able to offer promotional prices.

Such disagreements are not surprising. Both firms have monopoly power, so both want to make a monopoly profit. Of course, from one firm’s perspective, a monopoly profit by the other firm is equivalent to a tax that reduces sales and revenues.

Right now, there is a standoff, with Apple not offering any new shows from NBC. Negotiations are supposedly continuing. Who wins will suggest to me just how important the iTunes site is to the content providers.

The other interesting observation is how little Apple uses promotional pricing. I am thinking of buying a new Mac, and there is really little reason to hope for a “back to school” sale – well, I guess they offered an iPod to college kids this year, but generally you might as well not look forward to any big sales by Apple. Interesting pricing strategy -- and of course there is also the uniform 99 cent per-song price that has also been criticized by some copyright owners. Why not adjust price on the basis of demand for a song? Thoughts, anyone?

Who can't help but marvel at the obvious attempts by the liberal MSM to cast a negative pall on anything that could be even remotely linked to the Bush administration.

Yesterday in the Valley News there was a lead above-the-fold article with a Washington Post by-line (authors Christopher Lee and N.C. Aizenman). Headline: US Poverty Rate Down .3% in 2006. The second headline: But More Americans Lacked Health Insurance.

The article goes on to offset any positive aspect with a negative counter. For instance: "While median household income rose for the second consecutive year in 2006, the increase appeared to be driven by a jump in the number of people in each household taking on full-time jobs, rather than a rise in wages."

In fact this is the first time this decade the poverty rate has declined, and it was accompanied with an increase in median household income of .7%.

One of the top electronic game makers, EA, has shipped two new Mac games and will soon be shipping two other popular titles written for the Mac (well, maybe not really written for the Mac, but deciphered from the Windows version).

While still not quite matching the release dates of the Windows version of the games, EA's step into Mac-dom is welcome.

One of Apple's weaknesses has always been the lack of certain software, especially in the gaming arena.

With a few more hits like this, the only remaining reasons for not switching to a Mac would be.........ummmmmmhhhh...

At the local high school, Hanover High, nine 17-year old students (all males) have been charged with misdemeanor counts of criminal trespass and/or criminal liability for the conduct of others, in connection with the theft of final exams in math and chemistry courses. It sounds as if the kids hatched – and implemented – a plot to steal exams before test day, so as to be better prepared. I believe they also gave other students the exams as a gift, which causes one to further question the kids’ common sense (unless they sold the exams, which raises the old economics question of whether you can profit more from information by using it yourself or selling it).

I am sorry for the kids, but it certainly was not a very bright thing to do. And I would have to say that in my ranking of crimes, this is one notch worse than, say, colluding with another student to share answers. These guys not only (allegedly) violated academic integrity by cheating, but they also allegedly criminally invaded school property and stole something. Not good.

But, the most interesting part of this is that, naturally, some of the kids are children of folks we know. I will resist any urge to engage in schadenfreude, for the usual “there but for the grace of God…” reason. However…one of the poor kids is the son of Jim Kenyon, a notorious columnist for the Valley News. This is the guy who never misses a chance to tear into Dartmouth and generally side with the forces of bleeding hearts and evil. His column is one I never miss, and much like Paul Krugman’s, it never ceases to raise my ire. The last one he wrote got me upset because he criticized our local food co-op for having a 60-year old woman arrested for shoplifting (she was later acquitted by the judge). The co-op should have shown mercy on a nice old lady, Kenyon said; my reading was that he has one kind of justice for people he knows and likes and another kind of justice for outsiders and “ne-er do wells”. Nothing like a little discrimination, eh?

Perhaps Mr. Kenyon knew when he wrote that column that his son was being investigated for his own form of shoplifting?

The Valley News had some quotes from Jim Kenyon regarding the incident and his son:

He said Hanover High School’s “high pressured academic culture” leads to widespread cheating.

“The entire community must be willing to take a hard look at how it might have unwittingly contributed to this problem and work together to find solutions.”

Kenyon said the school’s cheating problems “do not begin or end with the final exams now in question.”

Give me a break, please! So we are to sacrifice our academic ambitions because nine kids can’t resist the pressure to steal exams? And this is not mainly the problem of the kids and their families, but of the entire community? Yes, society is to blame, competition is evil, we are not responsible for our own actions, we all have to work together…blah blah blah.

Friday, August 17, 2007

The Federal Reserve today singlehandedly created a 2% rally in the stock market and put to rest at least some fears of a credit crunch. I applaud Ben Bernanke and his colleagues’ move.

The critical distinction here is between bailing out investors who made bad decisions versus preventing a classic financial panic, of the “run on the bank” variety. I give my vote to the idea that there was indeed risk of a credit crunch, with a cascade of negative opinion creating feedback that was preventing capital from flowing to positive net present value projects.

The classic bank run occurs when depositors come en masse to a bank, demanding their deposits. These deposits are not, of course, in a vault at the bank but instead have been lent out to borrowers, with only some small percentage kept close at hand. If too many depositors demand their account balances, the bank must begin calling its loans, and therein lies the contagion effect.

In today’s market, the problem is not so much with traditional banks. But consider an investment bank like Bear Stearns. Bear Stearns discloses that one of its in-house investment funds held mortgage-backed securities that has declined in value so much that the fund is worthless – presumably the fund managers had leveraged their investments, so a relatively small decline in value could wipe out the net assets of the fund. Once disclosed, and given the overall worries about mortgage-backed securities, negative sentiment about Bear Stearns increases. In the normal course of business, an investment bank needs to borrow large sums of money to finance its activities. But given the concerns, and lack of knowledge of how bad the problems really are, who will want to throw money into a pot that might turn out to be rather empty? Afraid of being the claimant of lowest priority, nobody wants to lend money to such an institution under almost any conditions. This causes the investment bank to reduce its activity in a whole host of areas, and to sell assets it otherwise would hold, in order to raise funds. The vicious cycle begins, with lower prices in asset markets putting other institutions at risk…

I have been hearing from friends on Wall Street since at least June of the funny conditions in the credit markets. Credit was drying up, in the sense that lenders were just saying no, rather than just increasing prices by a reasonable amount to cover new risks.

It is funny how long it took for those fairly wide-spread debt market fears took to spread to the equity markets. One of those (many) instance where if only I had known for sure, I could have made some money. Ah, but how many times have I suspected some disaster only to see stock markets rise thereafter? Much better to buy and hold.

What the Fed did, in lowering the discount rate, was really quite genious. Very little additional credit will enter the economy as a result, and what does enter can be offset at an opportune time via open market operations.

But the Fed showed investors that they do understand that conditions are unusual and that there is a risk of a credit crunch. Credit crunches, panics, and runs should be prevented, and that is the job of the Fed. Bailing out mortgage bankers who loaned 100% of a home’s appraised value to buyers without verifying income is not the job of anyone.

By the way, I know folks in Hanover who had to pay for private mortgage insurance when they bought a house, and these are people with great jobs and in a great housing market. How is it that people in Florida and California are getting by with 100% loan to value mortgages, no income verification, and no PMI??

It’s really entertaining to read the New York Times, especially Paul Krugman’s gloom and doom editorials. I have a colleague who writes an investment advisory letter that exhibits a similar “longing for disaster” tone. Another example is all the climate change advocates who I detect thirsting for some Atlantic hurricanes this year (hurry up, Dean!).

The politics and world views behind so many pundits’ analysis is just so obvious, and so weakly denied. Krugman’s columns ooze not just gloom and doom, but I get a strong sense that he wants to see things melt down, just to prove that the Bush administration has been a total failure. My colleague’s letters to his clients are very similar. It’s not just that he thinks a real estate crash might come, but one gets a very strong sense that he will be happy and fulfilled if it does happen.

Here is an example. In today’s NYT, Krugman writes, “According to data released yesterday, both housing starts and applications for building permits have fallen to their lowest levels in a decade, showing that home construction is still in a free fall…The housing slump will probably be with us for years, not months…Meanwhile, it’s becoming clear that the mortgage problem is anything but contained.”

Free fall, years not months, anything but contained, lowest levels in decade…well, that last phrase is the one factual statement out of all of them. But given what housing has done in the last decade, to say that activity is lower than it has been for ten years really does not sound too bad. And even with housing prices haven fallen of late, has anyone checked the rate of return on owner-occupied housing over recent periods? Some slowing down or even declines is not exactly a crash.

How much you want to bet that Krugman criticizes the Fed for throwing cold water on his dreams? Don’t you share my hunch that many of these Democratic analysts are hoping that the housing crunch does indeed snowball into a recession, so that the Presidency will go to….Hillary? Obama? Edwards?

Saturday, July 14, 2007

Someone remarked the other day that if not for the war in Iraq, health care would be topic number one in the presidential race. That might well be true.

How will we devise a system to stop insurance from creating unlimited demand for health care services, creating a non-ending escalation of costs? Somehow we will have to give consumers incentive to limit their demand for services. This is tough, because when you are sick, or a loved one is sick, it is really tough to say that you cannot get treated.

Yet this has been the norm in all other important areas, such as housing, education, transportation, and food. Prices in these cases serve their normal role of inducing people to make choices to go without certain services, or at least to choose lower cost services. Many people routinely choose cheaper schools for their children, less expensive and less safe cars for themselves, and take jobs that are riskier to life and limb but pay more (e.g., fire fighters). Also, throughout history, unlimited health care has not been the norm.

Other countries are to a great extent using some kind of nonprice rationing such as waiting for service. In the US today, we have some rationing due to geography: living close to a major medical center will get you more, and more expensive, health care.

I have always felt that a part of the answer will lie in medical insurance being differentiated by degree of coverage. Some plans will not cover certain services, such as expensive transplants, or will at least have high co-pays for certain services, such as mental health.

The new Massachusetts regime requiring everyone to have medical insurance is moving in this direction. The Blue Cross Blue Shield website for the state lists several different plans at different prices and with different coverages.

What I was not able to find in the online descriptions of the plans is a key feature: lifetime maximum benefit. I think this will be critical. There should be some plans that are cheaper but have lower lifetime maximums, or in some way put a limit on what will be covered in certain situations (heart transplant, long term hospital stays, hip transplants past a certain age, etc). It is interesting that the lifetime maximum is not prominent in the plan descriptions -- indeed it is hidden. I am pretty sure there are lifetime maximums, and that they differ across plans. What will BS BS do with patients who hit that max and still want more coverage? Will our dear friend M. Moore have yet more fodder for another movie?

Friday, July 13, 2007

Not too long ago, I asked an accounting colleague about the tax treatment of someone selling things on an auction site like Ebay. Suppose you are making your living buying and selling collectibles on Ebay. How does the income you make get treated for tax purposes -- is it normal income, or is it capital gains? The difference, of course, is very large, as capital gains are taxed at 15% and normal income at higher rates. Similar analogies came to mind: how about a used car dealer? If I buy and sell cars, is the money I make a capital gain or normal income? It seemed like one of those issues where tax law would draw a somewhat arbritrary line. I can see an argument that if you are essentially a dealer, i.e., making a market in a collectible, then your income could be considered normal, rather than a capital gain, as you are essentially being rewarded for the service of providing a market. But it is going to be a tough call, and in some sense, illustrates the arbitrariness of treating income differentially to begin with.

Now comes the tax issue with the partners of private equity funds. Is the money that private equity fund managers make better considered to be normal income or a capital gain? This is a great topic for discussion. The current law may well make it legal for the managers to use capital gains rate; I suspect if they are doing it, they have had great lawyers look into the legality. So the question is what the right legal tax treatment should be.

But along comes the New York Times yesterday, with a front page story on "Tax Loopholes Sweeten a Deal for Blackstone." The intent of the story is clear -- to raise all kinds of shady questions about the tax fairness of aspects of the Blackstone IPO. The tactics are the usual combination of insinuation, vague claims, and muckraking language. Here are some examples:

"“These guys have figured out how to turn paying taxes into an annuity,” Ms. Sheppard said. “What people don’t realize is that the private equity managers, the investment bankers, all the financial intermediaries, are in control of their own taxation."

"The Blackstone partners sold the good will from their left pocket to their right."

"The ability to provide answers to such questions is why tax lawyers can typically charge $700 an hour or more. Just as fashion designers blend textures, colors and shapes, tax experts mix and match elements of partnerships and corporations, and bits and pieces of the tax code, securities laws, accounting rules and economics principles."

There are some interesting issues in the Blackstone deal. But this NYT story leaves me clueless as to what actually is going on, and whether it is at all questionable. Some more facts and clear language on what is being done would go SO much further than the kind of language pointed out above. The "annuity" that is referred to seems to be nothing more than the fact that if the goodwill can be written off against income in future years, then of course it creates a tax saving (assuming there is positive income). And to say that private equity managers are in control of their own taxation is really a stretch.

Well, I guess I am in control of my taxation too. If I earn less money, I will pay less tax.

Tuesday, July 03, 2007

Scooter Libby won't go to jail. He still has a felony on his record, and he still pays a fine and has probation. But no jail time, which must be a relief to him and his family. Bush could still pardon him, which would wipe the felony off the record.

This is fine with me, the punishment did not seem to fit the crime, and it was all a bunch of politics anyway.

Naturally NPR this morning led off the story with Joe Wilson complaining about the pardon and saying that there should be an investigation of Bush. For granting clemency? Give me a break. Go look up the list of pardons that Clinton gave.

The nice thing about Bush is that he did this one in broad daylight. You have to hand it to Bush on that front; he is not afraid to do what he thinks is right. Disagree all you want, but give the man his due for following through on some things.

Friday, June 29, 2007

Dartmouth Medical School receives over 5,000 applications for just 70 spots in its MD entering class. This is typical for medical schools across the country, and it swamps even the best business schools. That is a 1.4% acceptance rate, just amazing.

Lots of questions emerge from this, one simply being why so many students want to get an MD.

But my thoughts are more on the economics of health care. My knee jerk reaction to this unsatisfied demand is to question why medical schools don't expand and accept more students -- or why new schools don't open. I believe there are constraints put onto the expansion and opening of new schools by the American Medical Association, basically a supply restriction. My economics intuition would say that this is a monopolistic restriction that is meant to keep doctors' salaries high. Removing the restricton will get us more doctors, forcing their wages down, with the result of lower medical costs and improved patient welfare.

Not so fast, some observers say. Actually, in this market, an increase in supply will simply mean that the additional doctors will be employed, at the same wages, and therefore the medical expense bill will increase. Supply creates its own demand in this market, and the secret to keeping medical costs down is in fact to force restrictions in supply -- fewer beds in hospitals, fewer doctors, fewer exotic imaging machines.

I agree that there are problems on the demand side of this market, with insurance increasingly making patients less and less sensitive to cost.

But would expanding the supply of doctors really result in a worse situation? It should still cause doctors' wages to fall, even though the total spent might increase. This is true of any market -- the dollar size of the market after an increase in supply can rise or fall, depending upon elasticity of demand and of supply.

Is the dollar size of the market really what we care about? There is way too much focus in this country on total dollar expenditures on health care. I really find it hard to believe that the restrictions on supply of doctors is welfare-enhancing. Time to investigate the AMA.

Wednesday, May 30, 2007

I am not sure how I stand on the immigration reform currently being debated.

I lean, however, toward letting more people come into the country legally. There are a variety of reasons for this, but mostly I want to give as many people as possible the opportunity that this country offers.

Another really important reason for a more open immigration policy can be seen in my world of MBA education. At Tuck, we now have foreign students hired by US-based employers who did not receive an H1-B visa this year. That means they will have to use their optional practical training (OPT) visa, which gives them one year. They will have to re-apply next year for the H1-B, and they will have to be out of the country for a couple months in between the time the OPT expires and an H1-B is granted (assuming it is granted). Is it any wonder that US-based employers don't want to hire non-US graduates of the Tuck School?

Meanwhile the UK gives something like 5 years of work authorization for any MBAs from top programs (as determined by the UK government). No problem.

My worry is that companies, especially the very top employers such as investment banks, private equity funds, and consultancies, will migrate to a country like the UK so they have the pick of the world's best talent. The US will suffer as top companies leave. Is this one of the reasons why the City of London is increasingly the world's financial center?

Monday, May 28, 2007

It is Memorial Day 2007, and there was a good 15mph west wind, so my two boys and I went out to the lake to sail our Hobie 16 -- here is a picture of it.

We got this boat this winter, just rigged it for the first time on Saturday, and took two brief sails on the weekend. Not a lot of wind on those first trips out. Today was different, the wind was really blowing. We got out and were having a great time, with the boys taking turns going out on the trapeze.

I was just thinking I should take my hat off before losing it when the wind really started howling. Nice whitecaps were picking up, which on an inland lake means a pretty good blow. Then followed a series of errors. I saw the leeward hull starting to go underwater, and I figured that meant trouble. I told my older son to go forward, when I should have said move aft! He was also holding the mainsheet, and kept it nicely sheeted in. My youngest son was out on the wire, controlling the jib, and he had it sheeted in so it was giving us a lot of power. I think I might have turned downwind a little as well, accidentally.

Anyway, that leeward hull dug in deeper at the same time the wind picked up even more. All of a sudden, we were in a slowmotion pitchpole! The back of the boat came up, the hulls dug in, and over we went! My youngest son went for a ride up by the forestay, as he was still on the trapeze wire. I came down on my middle son's leg, and somehow I got my own leg twisted up in the jib sheet. That gave a little excitement as I lay in the water with my leg caught up in some ropes above my head. I have a nice rope burn on my shin and lost a good bit of hair. Anyway, I looked around and saw that we were all OK, although somewhat shocked.

So there we were in the middle of the lake, with the Hobie on its side and the three of us in the water. I had read about righting a Hobie, and we had a righting line (thanks to the seller of the boat for that one!) but of course reading how to right a boat is not the same as actually doing it...especially when you have just had the shi#&* scared out of you. But we all hung on the righting line and waited, and sure enough, the boat flopped back over. We jumped up, and I yelled, "Sheet in and feel the magic!" Away we went...with a little more caution.

The nice thing is, we won't be afraid of pitchpoling again, and we know how to right the Hobie. It was actually pretty fun, definitely character building. As someone once said, "It isn't a sport if it can't kill you."

Our local grocery store in Hanover is the Hanover Consumer Cooperative. It is a great store, with good selection of fresh fish, an in-store butchery department, and nice organic produce. They even had Copper River sockeye salmon this week, at $15 per pound. The only problem is that they sometimes venture a little too far into the liberal realm, like now.

The Coop is now advertising for a person to serve as Sustainability Coordinator. You have to be kidding. A GROCERY STORE, which should be operating on the thinnest of margins, wants someone to work on, among other things, "coordination with other organizations on collaborative sustainability programs."

This will probably cost the organization something like $60,000 per year, inclusive of benefits.

It is fun to dream about taking over the Coop and putting a for-profit enterprise in its place. The local market would still demand great food, and I bet we could get it at lower prices than the Çoop provides. Now there is an idea most people would not think possible: That a for-profit enterprise, with its "need" for "unnecessary" profit, could actually provide a service at lower cost than a not-for-profit.

My middle school son came to me with this twist on the famous Monty Hall/Let's Make a Deal probability problem. I am looking for the answer to the problem, and want the clearest most succinct explanation.

The original Monty Hall problem goes like this: There are three doors, and behind one is a prize. A contestant picks a door, but does not get to look behind it yet. Monty Hall, the master of ceremony (who knows which door holds the prize), opens one door, showing that there is nothing behind it. He then gives the contestant the chance to switch doors: The question is, should one switch?

(There are game theoretic aspects to this problem that are often ignored. Let's assume that Monty Hall ALWAYS opens an empty door and gives the contestant the chance to switch, no matter if the contestant currently has the right door or not.)

The answer is that one should switch doors. Not the most intuitive probability exercise for many people, but correct, given our parenthetic note above.

Now here is the twist. An exam in school will be either Monday , Tuesday or Wednesday, and the teacher has not said which. A student is assessing the odds of what day the test will be in order to study the night before. The day picked by the student is Wednesday, and she has arranged her schedule to study Tuesday night. Monday comes, and the teacher announces that the test will not be that day. So...should our student switch her pick, just like the contestant in Let's Make a Deal?

Saturday, May 19, 2007

As reported on Breitbart, Jimmy Carter had this to say about outgoing Prime Minister Blair:

"Former US president Jimmy Carter on Saturday attacked outgoing Prime Minister Tony Blair for his "blind" support of the Iraq war, describing it as a "major tragedy for the world". In an interview with BBC radio, Carter was asked how he would describe Blair's attitude to US President George W. Bush. He replied: "Abominable. Loyal, blind, apparently subservient. "I think that the almost undeviating support by Great Britain for the ill-advised policies of President Bush in Iraq have been a major tragedy for the world."

I gave up on Jimmy Carter a long time ago. A very smart man, but not enough appreciation for what Libertarians believe in -- the amazing power of free individuals to organize a decentralized but efficient society. I started really turning against Carter after he sat next to Michael Moore at the Democratric National Convention in Boston. And now comes this latest broadside. Has the man no decency? Does he really think that Tony Blair is subservient to Bush? I can't believe that liberals are willing to give Bush such a complement -- that he somehow manages to get a person of Blair's intelligence and demeanor to be subservient. Hmmm....is there an alternate theory out there that would explain Blair's behavior? Such as, he is doing what he believes to be right and best for his country?

Friday, May 18, 2007

I was listening to a great radio show on Bloomberg radio on my way out to my camp tonight. They had a CATO Institute fellow on, I think it was Brink Lindsey, and he was talking about what it means to be a Libertarian. He said how Libertarians are not comfortable with either the Republican or Democrat labels, but that they would tend to side with Republicans on economic issues and with Democrats on social and privacy issues. I agree. He also had a line about the Libertarian’s trust in the power of decentralized actions taken by free individuals. I agree there too. I had more trouble agreeing with his position on foreign policy. I suppose that the Libertarian tendency would be non-interventionist, simply on the basis of distrust of centralized government. But a Libertarian will certainly support my right to defend myself. The question comes down to where the line is that separates defense versus activist intervention.

Now don’t jump to conclusions, I generally agree with much of what Warren Buffett says, and specifically, I think that much of his investment advice is good. But I am a little worried that over 20,000 people are willing to shell out good money, and burn fuel, to travel to Omaha to watch Warren and his partner chat on stage for several hours. I also worry a bit about the message that many people seem to hear, even if it is not what Buffett would profess: that stock picking is good, and the lessons of modern investment theory, especially those concerning the value of diversification and indexing, are wrong.

The observations I would put to you are the following. On the one hand, my friends and colleagues who are of a liberal mind (small “l,” not liberal in the political sense but in the “liberal arts” sense) have no problem in seeing only the role of chance, random mutations, and natural selection when they observe the glory of some biological wonder like the human eye. No reason to bring in any role for divine intervention here; chance-based evolution takes care of it all. (Please, bear with me, I do like the theory of evolution!) But these same people, when they observe the glory of Warren Buffett’s investment returns, with the Berkshire Hathaway stock portfolio beating the S&P 500 20 out of 24 years, and an abnormal annual return of 8.6%, have no hesitation in pointing out….well, the equivalent of divine intervention!

We have this thing in auction theory called the winnner’s curse, which means that the winner of an auction needs to think carefully about what it means to be the winner: if there is uncertainty over the value of the item to bidders, then there is a very strong tendency for the person who makes the biggest error in value estimation to be the one who bids the most and wins the auction. Ex ante, all bidders’ estimates are unbiased, but ex post, the WINNER’S estimate is known to be a biased high estimate of the true value. And the more bidders, the more biased is the winner’s estimate. With 2 bidders, the highest value estimate is not too bad an estimate of true value; with 2000 bidders, the highest value estimate will be biased by several standard deviations.

A very similar phenomenon occurs with investment results. Start with 10,000 investors, and let them randomly choose stock portfolios over 24 years – no talent, just random stock picks. After 30 years, what do you think the winner of this contest will look like? I promise you, there is a very good chance that the winner of that contest will have beaten the average return in 20 out of 24 years, and have an abnormal return of at least 8.6% per year. Should we crown that investor queen, and travel thousands of miles to worship at her feet? Or should we say, “Hey, your ideas are great; I will take them into consideration. But what I would really like to borrow is some of your luck.”

Sunday, April 15, 2007

With all the cold weather of late, I have been thinking of how we should update our beliefs about changes in climate parameters as extreme weather events occur. This analysis applies, of course, to the warm weather events we had in early winter, and the earlier cold snaps back in September around here. My son is also studying conditional probability in high school right now, so this is good for him as well.

There are at least two “takeaways” from this little excursion. The first is that, as we should have suspected, extreme weather events should indeed lead to some updating of our beliefs about climate change, but not a lot. More important, and my second takeaway, is that this excursion is a great way to see some of the basic ideas of Bayesian statistics.

So I am considering how my beliefs about the probability of climate change taking place change when I observe a (local) extreme cold weather event. Intuitively, a cold event should make us wonder if climate change – which should result in warmer temperatures – is actually occurring. But also intuitively, we should be really surprised if we learn too much from one single weather event.

In words: The “posterior” probability of climate change conditional upon observing a weather event equals: The “prior” probability of climate change, Pr(climate change), times the probability of the event happening conditional upon climate change occurring, all divided by the unconditional probability of the weather event occurring.

If you multiply both sides by Pr(event), you see that both sides of the above equation give the probability of both climate change and the weather event occurring. The equality obviously holds therefore.

We normally use the term “posterior probability” for the left hand side of Baye’s Rule. The Rule tells us how our posterior probability is different from our “prior” probability after observing an event.

It is neat to see how Baye’s rule plays out in our climate context.

Let’s suppose that we have “diffuse” prior beliefs on climate change, that is, that Pr(climate change) from the right hand side of the equation equals ½. The question is how that prior belief changes after we observe an extreme weather event.

To do the analysis, we need to know Pr(event | climate change). Again in words, this is the probability of the weather event conditional upon climate change having happened. This is a key calculation. I take “climate change having happened” to mean that the distribution of daily temperatures in my local location having shifted to the right. Specifically, I assume that climate change has increased the average daily temperature by one degree. Let me also define my extreme weather event as a new record low temperature for the day April 16 in Hanover, NH. What is the probability of this event, conditional upon climate change having occurred? Well, it turns out that the long term average daily temperature for April 16 in Hanover is 33 degrees. And the standard deviation, I will assume, is about 7.5 degrees. The record low for this date is 15 degrees, having occurred in 1940.

If we assume that daily temperatures are normally distributed, then the probability of breaking that 15 degree record given the historical mean of 33 degrees is .008198. With climate change, the average shifts up to 34 degrees and the probability of breaking the record goes down: to .005649.

We now have everything that we need to complete Baye’s rule. The denominator of the equation is a little tricky; it is the unconditional probability of the new low temperature record. To find this, we use this equation:

This is just adding up the different ways that we could observe the extreme weather event: there are two ways, either through climate change or not through climate change.

We have all of these probabilities mentioned in the above discussion. If we calculate it out, we get Pr(event) = (.005649*.5) + (.008198*.5) = .0069235.

Now take the first term of Baye’s Rule and divide by the denominator; this is called the likelihood ratio. In our case, this ratio is .005649/.0069235 = .8159168.

Our posterior belief about climate change after observing the extreme cold event is about 82% of our prior belief before we observed the extreme event.

This is more than I would have expected going into this exercise. What determines how much our prior beliefs are affected?

First, note that the stronger our prior beliefs, the less we would change our priors after observing the cold event: The denominator of Baye’s Rule is a weighted average of the probability of the cold event under two different scenarios, climate change or no climate change. The weight on climate change increases as our prior belief on climate change increases, and this makes the weighted average move closer to the probability of the extreme event conditional on climate change.

As the denominator moves closer to the probability of the extreme event conditional on climate change, the likelihood ratio moves closer to one, and our prior belief is affected very little by the extreme cold event. Intuition: With strong prior beliefs on climate change, a cold event does little to affect them. With weak prior beliefs on climate change, a cold event makes us even more skeptical. Wonder why people are affected differently by events? Bayes would not be surprised!

The other thing that affects our much our prior beliefs change is the termPr(event | climate change) relative to Pr(event | no climate change). This gets to the heart of how informative the cold event is. Think about it: If climate change really doesn’t do anything to the probability of cold events happening, then these two probabilities would be equal, and the likelihood ratio in Baye’s Rule would equal one. (Why might climate change not affect the probability of extreme cold events? Well, if climate change did nto affect the distribution of daily temperatures very much, that would work.) And in that case, our posterior probability equals our prior probability. Makes sense, no?

On the other hand, what would make the extreme cold event very informative? This would happen if Pr(event | climate change) relative to Pr(event | no climate change) was large. This would be the case if climate change made extreme cold events very unlikely, so that the ratio of these two terms would be very small. Then the likelihood ratio would be small, and our posterior probability of climate change would be small relative to our prior probability.

Well, in conclusion, this got a little more complicated than I thought, but I learned a bit from it.

One lingering concern I have is over a “data mining” sort of issue. Let me put it this way: Seeing a record cold event in SOME locality in the country is much less informative than seeing a record cold event in one particular locality such as Hanover. Somewhere in the country is going to see a record cold event pretty often; one locality will see one only rarely. The above analysis does not apply to the event of just seeing a record cold event SOMEWHERE (well, it does apply, but the probabilities need serious adjusting -- especially the probabilities of observing extreme weather events).

All of this was stimulated because I wanted to spend the night at my camp. When I got there, this late Nor’Easter had blown out the electricity and the downdraft in my woodstove was so extreme I couldn’t get a fire started. Real pain. I was tempted to stay and cook my dinner on the Coleman stove, but came back home instead. Nasty weather.

I have never been a huge fan of Imus, finding him underwhelming with his reasoning.

But boy, did he fall fast. Now once I understood what the word "hos" means (showing my age and ignorance of popular culture there!) I did have to agree that what he said was really bad.

But was an apology not acceptable? Imus did way more than apologize: he grovelled. He grovelled to everyone, even to Al Sharpton. And everyone was after him, especially some of the Presidential candidates. Is the real story here that they all were not looking forward to having to appear on Imus' show several times?

April 15th is upon us, and my taxes have been filed. What was my marginal tax rate this year? Well, that is a really good question. It looks to me like I was right at the cusp of getting hit with the Alternative Minimum Tax. Last year, I did get caught by that, but this year, for some odd reason unknown to me, I did not. It was close; the calculation required computes your tax under the regular code and under AMT, and if AMT is greater, then you pay according to that.

In an earlier post this year, I noted my uncertainty then as to my marginal tax rate, saying it would be either 26% or 42%. It turned out to be more like the 42%, the regular code rate plus Medicare and the effects of phasing out exemptions and deductions.

What kind of tax code do we have, where during the year when I am making income-earning decisions, I cannot determine what my effective tax rate will be? I mean, let's just totally screw up our incentives. If I had made an additional $10,000, I would have netted $7200 (AMT, with the rate this year of 28%) or $5800 (regular code). Anyone who says that a 14% difference in your rate of pay will not make a difference in what you do, is talking nonsense.

As I said before, the Democrats have a chance to show the country that they can respect individual privacy (easy for them); construct a reasonable tax code and manage government spending (not too hard; Bill Clinton did a fair job); and maintain a strong national defense posture (seemingly impossible for the current Democrats). Probably if they got two out of three, they would have a chance to govern for a while. One out of three should mean the wilderness for them.

The most recent guest post by Professor Ben Herman of the University of Arizona is also worth reading for anyone who is willing to question some of the predictions and policy prescriptions being bandied about.

Lot's going on with Apple and DRM. The EU is threatening antitrust action against iTunes, and Apple and EMI announced a new deal on DRM-free music.

Let's think about the EMI deal. EMI, with Apple's partnership, is going to make its library (ex-Beatles!) available on iTunes without DRM, and in close-to-CD audio quality.

The catch? Instead of the usual $.99 per song, EMI's songs will go for $1.29.

What accounts for the higher price? We have a few choices, not mutually exclusive:

1. Songs unencumbered by DRM are worth more, so the price is higher.

2. Songs of higher audio quality are worth more, so the price is higher.

3. Songs without DRM are going to spread more, reducing purchases by other users of the same song, so they have a higher marginal cost and therefore should sell for more.

4. As I pointed out in this post, Apple should be concerned that if iTunes songs are priced below their "stand-alone" profit-maximizing price, then entry by competitors into the portable musice device market is aided. From the perspective of pricing iTunes songs and iPods, Apple should be pricing songs lower than their stand-alone price, but above marginal cost. To eliminate the aid to entry, Apple has incentive to introduce DRM, preventing iTunes songs from playing on other devices.

If Apple drops DRM for some songs, then to maintain a deterrent to entry, it should increase the price of songs.

5. Last argument, it may be that EMI is simply charging a higher royalty to Apple for its songs (why?) and Apple is simply charging the relevantly higher price.

My choice of answers? A combination of all of these. Look at it from EMI and Apple's perspectives. Everything points to a higher price for the DRM-free songs (and by the way, the DRM-encumbered songs are still available at a lower price). "Let's try it and see what happens."

Based on my own recent experience in hitting the 5-machine limit, I would probably opt for the higher priced version. If there were no choice available, I would likely buy almost the same number of songs at $1.29 instead of $.99, when the higher price was for a higher quality and DRm-free version.

Friday, February 09, 2007

Steve Jobs posted this week on the Apple site a letter in which he argues for the abolition of digital rights management (DRM) software for online music. If DRM were abolished, then any songs purchased from iTunes could be played on any device, and vice versa -- music purchased on any other sites could be played on iPods.

Not too long ago, I wrote a post on why it could be in Apple's interests to prevent iTunes songs from playing on other devices. My basic argument had to do with assumed pricing of songs on iTunes. I argued that Apple was pricing songs above marginal cost, but below the price they would set if they were not also selling iPods. Essentially, Apple was, I argued, trying to prevent new entrants into the portable music player market from getting the benefits of relatively cheap songs from iTunes. New entrants obviously would find entry into the device market easier with a full iTunes library at low prices ($.99).

So what might have changed, in order for Jobs to call for no restrictions on songs purchased on-line?

Three possibilities. One, if Jobs' description of the contracts with the music publishers is correct, then they could shut down the iTunes site within weeks of a determination that Apple's DRM has been hacked. That is a big albatross to have circling over one's head all the time. It is not clear that Apple will be able to stay ahead of the hackers. Jobs may have had to agree to this contract clause when nobody knew whether iTunes would take off, but I suspect he has a bit more negotiating clout at this point.

Two, with more and more online music sellers, we are likely to approach marginal cost pricing of songs. With marginal cost pricing, and more music available, the ability to deter entry into the device market by keeping iTunes songs only for the iPod disappears.

Three, I don't think the incentive to deter entry into the device market is nearly as strong as it was when the iPod was new. Apple has a huge lead, both technologically and in the marketplace, and it is moving on to a whole new competitive arena with the iPhone. The advantages to Apple of having (cheap) songs from other sellers able to be played on its iPods and iPhones outweigh the advantages to Apple of having its songs not be playable on other devices.

A really good blog to keep up on science of climate change that you won't read elsewhere is Roger Pielke's blog.

Roger notes two attempts to remove state climatologists -- David Legates in Delaware and George Taylor in Oregon -- because of their failure to follow the consensus views on global warming. Roger also gives the cite to Heidi Cullen's (of the Weather Channel) post where she speaks about having the American Meteorological Society remove their seal of approval from meteorologists who "can't speak to the fundamental science of climate change" and about the inability of some meteorologists to differentiate between "solid, peer-reviewed science and junk political controversy." Take a look at Roger Pielke's resume and tell me if you see anything other than solid, peer-reviewed science. About all you will see on his site is peer-reviewed science, and it is good stuff.

So what kind of consensus is this, if by speaking out against it you are vilified?

Wait -- another late breaking item, Ellen Goodman from the Boston Globe says

"I would like to say we're at a point where global warming is impossible to deny. Let's just say that global warming deniers are now on a par with Holocaust deniers, though one denies the past and the other denies the present and future."

Now if you read my post on warming from February 1, you will see I agree that global warming (that the average global temperature has increased in the last 100 years) is tough to deny. But that, I don't think, is what Ms. Goodman means when she refers to the deniers of global warming. I suspect that if I said to her that maybe the best response to warming is to make sure that the world economy grows at a good rate for the next 100 years so that our children have the capital and capacity to adapt to climate change, she would consider me a denier. Or if I said that it simply did not make good economic sense to spend a lot on reducing CO2 given the cost of reductions and the relatively minor benefits that would be forthcoming, she would consider me a denier. Or if I said that it was not clear just how much of the warming of the last 100 years was due to anthropogenic greenhouse gas emisssions, she would consider me a denier. Read her editorial and tell me if I am wrong.

At any rate, bringing the Holocaust into the argument over climate change is just going way over the edge.

Thursday, February 01, 2007

The news media is in high gear in anticipation of the IPCC summary for policymakers that will be issued tomorrow. I think I will have to go into hiding for a couple days or my blood pressure will go through the roof. Leave it to the French to darken the Eiffel Tower to reflect the seriousness of the event.

So about 12 years ago, in my Environmental Economics course at Tuck, I had a "skeptic" in to class to discuss climate change -- Robert Balling. Now in the interest of balance, I also invited to the class Donella Meadows (Limits to Growth) and she did attend. It was one of my all time favorite class sessions. The students who were there probably still do not realize how lucky they were to see Balling and Meadows square off -- and agree on much of the science, but not on the policy implications!

So it sounds like one of the news bytes will be that mankind is "very likely" to be a cause of some (how much?) of the warming we have observed. Twelve years ago, Balling, a skeptic, would have agreed to that. I remember him going through the data, with a focus on moderate warming, especially at night and in winters, and more rainfall generally. That, he said is global warming. The question then, and now, is what we should do about it.

So the IPCC summary will try to make a big deal out of the "very likely" language, and all the media will try to use it to say that all skeptics have been discredited. I don't know of any skeptics who deny the theory of climate change (i.e., the causal relationship to CO2) or indeed any who would not agree that some of the warming we have observed in the last 100 years is "very likely" due to human influence.

That is just not the point.

It will be interesting to see the spin if, as I expect, the expected temperature increase and expected sea level increases both fall from previous expected values. How do you spin that into more of a crisis?

Tuesday, January 16, 2007

This is probably a naive question. Maybe someone can answer it quickly for me.

The Manhattan Project started in 1942 and in 1945 the United States detonated three nuclear bombs, including an enriched uranium bomb and a plutonium bomb.

Fast forward sixty years: The Iranians have been allegedly working for several years on developing a nuclear bomb but are, by some projections, still years away from being able to produce one (leaving aside the ability to deliver it).

Friday, January 12, 2007

What a wonderful company Apple is. Who else can you turn to for virtually all of your Christmas presents? From iMacs to Macbooks to iPods, plus all the third-party complementary products, the possibilities for great gifts are unending.

But the topic of the evening is profiting from induced changes in competitors' market values.

S. Jobs announced this past week the new iPhone from Apple (so long as it works on Verizon, I see several such phones in my family's future).

Apple's share price increased by 8.3% on the day. This is pretty amazing, given that the market was expecting a big announcement. Apple clearly surpassed expectations.

But who should suffer from Apple's mobile phone innovation? Two companies that should be hurt by Apple's perceived successful entry into the mobile phone market, in terms of revenues, profitability and value, are Palm and Research in Motion (makers of the Blackberry). Palm fell by 6%. Research in Motion fell by 7.9%.

Now Apple officers trading in Apple shares would clearly violate insider trading laws as the officers of Apple owe a fiduciary duty to Apple shareholders. But that legal argument does not apply to Apple officers, or Apple itself, trading in the shares of Palm or Research in Motion. No fiduciary duty owed there, and mere trading on proprietary information is clearly not illegal. In fact, one could argue that Apple created and owns the information on its innovation, so why can't it trade on it?

Wouldn't it have been a great trade to sell short Palm or Research in Motion, if you knew just what S. Jobs was going to do at MacWorld? And guess what -- for an Apple employee to do such a trade would not be illegal (to the best of my knowledge that is, and I do note that it could violate Apple corporate policy). Perhaps the best idea would have been for Apple's corporate pension fund to have sold short shares in competitors prior to the conference. Not only would Apple make money from the entry into the mobile phone market, but it would also make a fortune from the decline in fortunes of its competitors!

About Me

I was born in the Upper Peninsula of Michigan, went to Northern Michigan University undergrad and UCLA for my PhD in economics. I am Norman W. Martin 1925 Professor at the Tuck School of Business at Dartmouth College. I lean libertarian, but for lack of political success on that front I tend to support the Republican Party.
The usual boilerplate applies: What I write here represents only my views, not those of my employer.